Page and Associates Ltd.

Family Wealth Management

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Market Commentary

As we close out November 2023, we are glad to see major equity market benchmarks back to positive returns for the year. It has been a volatile year for stock and bond markets as economies around the world adjust to the fastest and sharpest interest rate increases on record following pandemic-era record lows, still buffeted by geopolitical shocks. The Israel-Hamas conflict sent markets tumbling in October, but those losses were more than made up by the end of November. This conflict continues to present risks, as does the Russia-Ukraine conflict and uncertainty on government funding in the US.

We believe that interest rate increases are now behind us in Canada. Some market commentators believe we may see rates begin to decline in the second half of next year, which would be a positive for both stock and bond markets. There are signs that rate increases are increasingly being felt by Canadian consumers, and we may already be in a recession: Statistics Canada reported a 1.1% decline in GDP in the 3rd quarter, and had they not revised the 2nd quarter GDP decline to a small positive, we would now have met the technical definition of a recession. Inflation statistics continue to drift lower, now within the old 1-3% target range, but not yet at the 2% the Bank of Canada keeps saying is the real target. While a recessionary outlook is not positive for stocks, equity markets in the past have begun their next bull phases before statistics confirm the end of a recession, but we should expect continued volatility.

In the US, 3rd quarter GDP growth was very strong at +5%, raising questions about whether recent rate hikes are yet cooling demand enough to cool inflation. Thomas Barkin, President of the Richmond Federal Reserve bank, believes that inflation could soon fall materially as the impact of higher interest rates is fully reflected in the US economy. Despite robust GDP growth, the talk he hears on the street shows signs of weakening, with the decline in consumer discretionary spending as an early sign that higher rates are having an impact, though business capital expenditures are still strong. Many product manufacturers raised prices during the pandemic because they could, and will be reluctant to roll back those increases, until they are forced to by weaker demand. Even if no price cuts are coming, the lack of further price increases should eventually flatten inflation, though Barkin says further rate hikes are not off the table if this doesn’t happen.

Fed’s Barkin says rate hikes are still on the table if inflation doesn’t continue to ease (cnbc.com)

Market commentators still have a wide range of opinions on the outlook for interest rates and the economy, and the tug of war between the shifting balance of opinions leads to the high volatility we’ve seen this year. Maintaining adequate cash reserves to avoid selling at lows is always prudent, made easier now that liquid cash deposits are yielding over 4.5% for the first time since the 2008 Financial Crisis. 

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Bailing on Bonds?

2022 was the worst year for bond investors since 1990, the last time interest rates spiked significantly in a short period of time. Many investors may be tempted to sell their bond fund holdings after such a bad year, but that would likely not be prudent. The below article from TD Investment Management notes that yields on bond portfolios have risen as central bank and GIC rates have increased, so bond investors are now earning close to 5% interest compared with the 1-2% they would have expected a year ago, and will recover last year’s losses as the bonds in their fund return to their Par value as they get closer to maturity. Bonds or GICs continue to play an important defensive role in a well-diversified portfolio, offsetting the higher volatility of stocks and other equities.

Click here to read: Bailing on Bonds? Why now is not the time

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Fall Economic Outlook – Video from CIBC Capital Markets

CIBC chief economist Avery Schenfeld provides this 4-minute video summarizing his economic outlook. A recession is likely on the horizon but markets have already priced in some slowing. “We’re still hopeful that…two years of minimal economic growth as opposed to an outright deep recession is possible. The central banks are right now still in the process of finding out what interest rate it’s going to take in order to get us there.”

Watch the full video commentary

Video Transcript

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Bank of Canada Increases Overnight Rate to 2.5%

Today, the Bank of Canada surprised markets with a 100 basis point (1%) increase in its target overnight lending rate to 2.5%. (Press Release: Bank of Canada increases policy interest rate by 100 basis points, continues quantitative tightening – Bank of Canada).

Markets had been expecting another 0.75% increase based on the bank’s comments in May that it expected the neutral rate (neither stimulative nor restrictive to economic growth) to be about 2.5%, but that it would re-evaluate this target based on inflation and other statistics. Inflation has remained persistent in the face of ongoing supply chain disruptions, Chinese COVID lockdowns, and the war in Ukraine, and job vacancies remain at record highs without sufficient labour force to meet the demand surge after this year’s re-opening.

The Bank of Canada said this week that the neutral rate may need to go to 3-3.5% to balance demand to available supply, and the economy was strong enough to absorb the interest rate increases without causing a recession, so it wanted to ‘front load’ the rate increases to reduce inflation pressures immediately, and avoid even higher targets being needed in the long term. We should therefore expect a further rate increase at the bank’s next meeting September 9th, and at the next US Federal Reserve meeting July 26-27.

While the bank does not believe the higher rates will cause a recession, they do expect economic growth to slow. Still, their expectations are for reasonable growth rates of 3.5% this year, 1.75% in 2023, and 2.5% in 2024. Because inflation measures price changes from past levels, they expect about 8% inflation readings for the balance of the year, but a return to 3% by the end of 2023.

Bond markets had anticipated further rate increases so their yields and prices had already adjusted before the announcement. Top GIC rates are now over 4% for a 1-year term, and top daily interest deposit rates of 1.3% may see an increase in the coming days.

Video summary: Monetary Policy Report – July 2022 – Bank of Canada
Full Report: Monetary Policy Report – July 2022 (bankofcanada.ca)

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Interest Rate Commentary

With surging central bank rates and bond yields, GIC interest rates have also risen sharply this year, with top offers on 1-year terms now paying almost 4%, and 5-year terms over 4.5%. These are the highest GIC rates we’ve seen since before the 2008 Global Financial Crisis (Source: Cannex Financial Exchanges).

Bond yields spiked earlier this year on expectations that central banks would hike rates in response to building inflation pressures. The chart top right compares bond yields of all terms before the pandemic in blue, December 2021 in green, and June 2022 in red – quite the surge in a short time, especially in the shorter terms (Source: www.ustreasuryyieldcurve.com).

Top GIC rates are usually higher than government bond yields of the same term because of two risks: one is that you can’t redeem or sell a GIC before it matures, the other is that the bank issuing the GIC could fail. Investors control the locked-in risk by staggering GIC maturity dates and by maintaining some liquid cash deposits in case some cash is needed between maturity dates. They can also control the default risk by only working with institutions that are deposit-insured.

Because you can’t sell GICs before they mature, their reported current values are always based on the guaranteed principal plus any interest accrued, thereby masking the impact of rising market rates. You might be sad your interest rate is lower than currently available, but can be glad you won’t see any decline in value on your statement.

Because bonds can be sold in the market before they mature, their market values will drop when market yields increase. However, just like GICs, bonds will still mature at their full principal value, so investors who hold onto them after a decline will still earn the same yield they had expected when they bought them. In the graph below, we show a 5 year bond bought December 31 2021 at the then-current 1.27% yield, which would be worth about $106.50 with accumulated interest when it matures December 31 2026. By June 30 2022, market yields for a 4.5 year bond had risen to 3.00% implying about a 7% reduction in the value of the original bond to keep its yield aligned with the higher market yield. In the graph below you can see that as time passes and the maturity date gets closer, the market value of the original bond would gradually recover to 100% of its principal value, plus the investor would have all of the interest expected originally. The investor actually has an advantage since the interest payments can now be reinvested at higher rates than initially expected.

Once the market value has dropped in response to higher market yields, the effective return to maturity will be in line with the market yield, so there is no advantage to be had trading out after yields have already increased. In this case you would be sad that your market value has declined, but you might be glad that your yield to maturity is now much higher.

If market yields moderate again once inflation is back on target, bond prices should recover. If you are not keen on such fluctuations in the defensive sections of your portfolio, perhaps a series of GICs with staggered maturities would be a better fit.